Crypto taxes: an advanced look for validators, stakers and investors

In preparation for crypto tax season, Blocknative CMO John Jefferies sat down with Pat White, the CEO of crypto accounting firm Bitwave, to take a deep dive on the latest on everything validators, stakers, MEV searchers, and crypto traders need to know.

Topics covered include:

• staking rewards and taxes
• reporting requirements
• MEV rewards tax complexities
• and more

*This is not financial, legal, or tax advice. This material has been prepared for informational purposes only*

Listen to the recording

Transcript

This transcript has been edited for readability

JJ: My name is John Jeffries. I'm the CMO at Blocknaitve. I’ve been working full-time in blockchain since 2017. Tracking digital currencies since far before that with digicash and eCash.

I originally went down the rabbit hole after reading Nick Szabo’s white papers on smart contracts and was totally pilled at that point and even worked with Nick at a company called IronKey. Prior to Blocknative I was the CMO at Cyphertrace which is now part of MasterCard.

I joined Blocknative a year and a half ago because I was intrigued and fascinated by the opportunities of the pre-chain layer. Blocknative is a leading Ethereum block builder. The company's real-time infrastructure lets validators and searchers optimize staking rewards and trading profit. And our transaction orchestration platform provides complete transaction control.

Founded in 2018, Blocknative helps inform and power forward thinking projects such as Lido, Metamask, Curve, Balancer, the Ethereum foundation, Polygon, and others. Now I have been excited about this conversation all week long because today we have with us Pat White. Pat is the co-founder of Bitwave, an enterprise platform that customizes accounting and bookkeeping for taxes and tax tracking for on-chain transactions. 

From my perspective tax issues have kept me away from being an active participant and active trader for years and years. With companies like Bitwave, now we can trade and make sure that we stay legal with respect to the US government and other government tax obligations.

Pat is a recognized software and engineering leader with over 10 years of experience building enterprise software at top tier teams including Intuit and Microsoft. Prior to Bitwave, Pat started a consulting firm which developed an enterprise search engine and was acquired by Cisco in 2016.

Pat: What a great intro, man! Thank you! I appreciate it. Bitwave is the number one digital asset tax and accounting solution for businesses that use crypto.

So the way that we think about the world is you have, you know, the retail users out there who are really just looking to do their taxes. So you know folks like yourself you just sort of mentioned. I bought some Bitcoin, bought some Ethereum and really I'm just going to be reporting my taxes at the end of the year.

That's kind of a whole different ball game to what we do. What we do is focus on businesses who care about taxes obviously, but really their day-to-day operations. I always like to joke that the difference between taxes and accounting is subtle. 

But taxes tell you how big a check to write to the IRS. Accounting tells you how much money you've been making. So people tend to like accounting a lot more than the tax disciplines and things like that because it is more about “how much money have we been making on our staking and MEV” and all that sort of stuff.

So Bitwave focuses on how do you enable digital assets for enterprises? How do you focus on the accounting and tax implications for that? And in a lot of cases like what we're going to be talking about here today, it is a lot about “I as an individual making money here (or as a business making money on validators), I need to make sure that we are correctly accounting for that revenue. Accounting for all the activity that we're doing. And then being ready to pay taxes on the other side of it. 

So that's Bitwave in a not nutshell. 

John: Great, that was an excellent overview! So who has to pay taxes? When do they have to pay taxes and what are their obligations? 

Pat: If you are a US citizen then you have to pay taxes (laughter). If you are a US domicile business, you have to pay taxes. If you are a business that does business in the US, you most likely have to pay taxes. 

That can be a little bit dicier and you will often have to pay some form of taxes in the country of your origin, unless you are based out of the Caymans or somewhere like that. 

I've been doing this since 2018 and when we started doing this in 2018, we'd go to these conferences. Me, and my cofounder, we’d go to these conferences. And someone would walk up to our booth. They would say “hey what do you do”? And we would say “we do crypto accounting and taxes”. And they’d look dead pan at me like “I will never pay taxes on crypto, I do not do it.” 

And it's like “all right, man!” That's a perfectly reasonable stance to take if your freedom is not an important thing to you. And if you don't really care about things like money. 

But we don't hear that as much anymore. So at this point, if you're in crypto, you want to figure out a way to get your taxes done correctly. There's a lot of great solutions if you're an individual. We partner with a lot of groups, we really like Cointracker. They’re a really good group of individuals. But, if you are a business, you want to get serious about digital asset accounting.

You need to know exactly how many tokens you're bringing on your inventory. What you do with those tokens, what your gain loss is, all that needs to be on your books because your investors are going to ask about it. 

Your investors are going to be genuinely curious regarding how much money you're making as part of any different activity you have with crypto. How much money you're making holding crypto or selling crypto, whatever it is. And we'll talk about all these things kind of going on, but the short answer is: probably everyone has to pay taxes and don't it's not the best idea to say “hey, we're not going to pay taxes”.

John: So, and I've declared mine, but if one hasn’t declared their crypto earnings and they’ve finally come to the point where they feel it’s an obligation they must meet, what’s that first year look like and feel like to them? Are there any specific decisions they need to make about how they account for it? FIFO vs LIFO? Or other sorts of issues? 

Pat: So if you haven’t been paying your taxes and you are looking to come right, there's a lot of different options for how you want to handle that. But first and foremost, get in touch with some sort of tax professional.

Get in touch with a CPA, tax professional, whatever it is. One of these funny things I like to talk about, you know, it’s true. To the benefit of the guy who came up to my booth and said he would never pay taxes: Many people in crypto are nervous about taxes, don't really like the notion of taxes, and honestly maybe have some libertarian proclivities that lean them towards not reporting income, not paying taxes, things like that. 

It’s an interesting way to think about it but it’s not the best idea because at some point you are going to have to declare your income.

There's a natural proclivity to say I’m going to put off declaring revenue, I'm going to put off declaring staking rewards, it's an interesting way to think about the world.

You naturally want to say I don't want to recognize the income right now because that's gonna hit me today. But the way that crypto taxes work, is that the day that you recognize the income…so we’re going to spend a lot of time talking about staking and validating income today, especially around ETH 2. Well I guess it’s just Ethereum now.

In particular, as you are getting ETH deposited into your account. Obviously today this would be your unwithdrawn account, but if you're using something like one of the liquid protocols that let you have some amount of liquidity there. As you are getting tokens deposited from validating actions (block rewards or MEV), you are getting revenue in that token. 

An example of this is, let's imagine a world where we didn't use money every single day, but we still have the IRS. If I have a butcher shop and I have a piece of meat and someone comes in and they trade painting my house for a piece of meat, that is revenue. You do have to recognize that type of transaction as revenue. 

Same thing goes for if they give you something more tangible. Say they give you a carved wooden sculpture, that's revenue and then of course, that extends to Ethereum.

So someone gives you ETH, you give them meat, that is revenue that you have to recognize. The way these laws all work is that the moment you get the eth, you are striking a price that is both the income that you are recognizing. 

So someone pays me today, ETH’s at 1777, whatever it is. I'm gonna say “okay, someone gives me one ETH today for work”. I got one ETH of revenue which is worth 1700 dollars. That 1700 dollars is both my income, but then also it is my cost basis going forward. 

So the nice part about that, is that now I've struck a lower cost basis. There are reasons to not want to put off, recognizing income. Because a lot of us believe that next year, Ethereum is going to go up. So if Ethereum goes up to two thousand dollars, four thousand dollars next year and I had the chance to recognize both income at 1700 today as well as I have the opportunity to set my cost basis for ETH at 1700 dollars, that’s great. 

What you want is you as a holder of securities now, it's really hard to time the market, but you really do want to minimize the amount of income you’re recognizing and, as much as possible, take that sort of normal income and turn it into capital gains, which is what you are actually getting when you go and sell the ETH later. You are paying capital gains tax on the delta between that 1700 or whatever you sell it at. And capital gains tax in America is much more favorable than income tax for tax purposes.

So at a high level, don't put this stuff off because you think that that will be tax advantageous. It might be, don't get me wrong, but don't just assume out of the blue that this is going to be advantageous.

There are very real reasons why you actually do want to be more aggressive about getting all of your stuff in order. If you owe back taxes, if you've never known this before, talk to a professional, especially someone that knows crypto.

You can reach out to us. We have an enormous network of CPAs, accountants, tax folks that all know crypto extremely well. They can then help you do all the recognition. And honestly right now is not a bad time to do it. It's not the worst time because the markets are kind of down.

We're sort of in a bear market so it’s not a bad time to go and do any recognition you need, potentially pay any fines you need, and then get ready for the bull market coming up next. Hopefully with lower cost bases ETH. 

John: And so is it worth harvesting losses at this point? With the markets being down? I’m assuming some people are upside-down.

Pat: So tax loss harvesting is a really interesting thing to talk about. First and foremost, be a little bit careful with this, because even in the best of times, tax loss harvesting has an iffy relationship with the government.

The way to analyze any single problem in the tax world is to say “what would the IRS do in a perfect world” and then search for any situations where there's possibly a loophole or something that's been created after that.

But always assume that the IRS is out to get the max amount of money. Tax loss harvesting is a really interesting mechanism. We've had what are called wash trading rules in America for a long time. It's actually really severe, the way they wrote the rule is very severe. 

The way the wash trading works is, say, I own Microsoft stock. Microsoft goes down a dollar, I sell it and buy it right back and theoretically, buy it back that day. That is what tax loss harvesting is.

When you do tax loss harvesting on crypto, it looks like Bitcoin drops below your buy price, you sell it, you buy it back right away. And theoretically you're then taking that loss and resetting your cost basis to lower.

This was being done in the public markets and a law was passed that made it not acceptable from an accounting perspective, from a tax perspective. So that the way it works today is if you sell and then rebuy the same security, like Microsoft stock, within a month, you actually end up getting penalized where your whole cost basis resets to the higher of the two cost basis. Or the lower the two cost basis, I’ll have to remember exactly how they do it.

But basically they wrote the law to heavily heavily disincentivize this and you are not allowed to take the capital loss on that transaction. So it does do a reset of your cost basis, but you don't actually get a benefit from it.

Really really strange. Well actually, it's not at all strange. If you analyze every single thing around taxes, it comes down to how to maximize money for the government because that's how they're optimizing this stuff. That obviously makes sense.

So in crypto, depending on how you read a particular law, there is a way to make an argument that wash trading rules do not apply to crypto. And so all the tax laws harvesting stuff that you've seen out there generally does depend on that particular rule.

Now, again, it's a particular reading. A different reading of the rule, especially one that relies on what we've learned about how the government thinks about all this as securities, says that, in fact, washing trading rules do apply to crypto, and you shouldn't do it.

So that's a very long way of saying that, if you are looking at tax loss harvesting from the perspective of “I have Bitcoin, I'm going to sell it and buy it back immediately to take a loss and reset my cost basis”, there's a very good chance that that's not okay today.

And even if it is okay today, there's a very good chance the IRS will do a retroactive rule around it. So in the normal world, we also are very careful about laws. It's very hard to pass a law that's retroactive. If someone decides they want to make things in your house blue a crime, it's very hard to pass a law that makes it illegal to have painted your house blue already. If for no other reason than political reasons, but it's also hard from a jurisprudence issue.

The IRS does not suffer the same issue. If they decide that wash trading was always wrong for crypto, they make a declaration and it’s something where you have to go back and restate five years of taxes where you were basically doing tax loss harvesting.

So again this is a place to go talk to a tax professional. But one of the things that you can do is, the way people do tax loss harvesting in automated brokers like Betterment and things like that is they tend to go between equivalent securities.

So say I have money in Betterment and I turn on tax loss harvesting, they put the majority of my money in a Vanguard Admiral mutual fund. And when I turn on tax loss harvesting, assuming the markets have gone down, what they're going to do is they're going to sell the Vanguard mutual fund and they're going to buy a Fidelity mutual fund that essentially has very, very similar exposure to the market.

So it's a Fortune 500 weighted, average weighted fund. They're going to sell one and buy the other. And the idea is that they are essentially equivalent instruments even though they offer completely segregated actual securities from a legal perspective.

So there are potential ways, talk to your tax advisors about this. There are potential ways to do tax loss harvesting that would be friendly even if wash trading rules change. One example is going from BTC to wrapped BTC.

Depending on your tax advisor, you might be in a situation where wrapped BTC is treated as a separate security from BTC. If that's the case, then selling your BTC and buying wrapped BTC is a form of tax laws harvesting. It's kind of equivalent to that Admiral fund thing without it being straight wash trading. 

Now even that is kind of iffy because a lot of people treat wrapped BTC as equivalent to BTC. When you do that treatment, you get this really great benefit that trading into wrapped BTC does not create a disposal of your BTC.

So if I have BTC at five dollars and I wrap it, I don't want to suddenly pick up a capital gain of $28 thousand dollars. I wanted to say hey, no, it's the exact same instrument underneath it. So in that case, you’re basically treating the instruments as equivalent, so then obviously these wash trading rules don't apply to that. 

So then you might look at something else like going into a liquidity pool. So let's say, you go into a liquidity pool with BTC and USDC or BTC and ETH. That's a way to basically, trade away, dispose of your USD, your BTC, acquire a Uniswap liquidity pool token, something like that. 

There's other other options floating around here, but hopefully this shows the complexity with which this is, it shows the danger in some ways of doing this wrong. Because you want to be very thoughtful about this. Just because someone posted an article about tax loss harvesting does not mean that a) it’s okay b) it’ll be okay forever and c) that you should do it. You should absolutely talk to somebody who can give you guidance.

John: That matched really well to the advice that I received. But as much as I'm a fan of CoinTracker, and it's really helped me manage my annual gathering of data, they torture me on a weekly basis with my harvestable loss. And a) I don't want to do it and b) I don't need the weekly reminder of how much I lost. 

Pat: (Laughs) Yeah, it's been a tough year for us all.

John: Well, you know, the advice I got from my advisor, you know, is if you like your position and you believe your positions are coming back, then just sit tight and ride it out. 

But, that said, I've heard that there's various different issues for corporations holding non-stable, volatile tokens like Bitcoin and Ethereum in their treasury. But I don't understand that at all.

Pat: Yeah, let's talk about what it means for businesses to hold crypto. Again, this gets a little bit back to this idea of accounting versus tax because most people are not doing this. If you are validating and you’re on ETH 2 using Blocknative to build blocks, and you're getting some revenue off of that, you're not really following what would be called GAAP (general accepted accounting principles) as an individual.

You should still be recognizing the ordinary income for taxable purposes, but you don't really care about accounting for it correctly. The second you are a business, you actually do need to account for it correctly. When you are a business you pick up a responsibility to tell your board, your investors, potentially the government, your Information about your position as a company.

And so there's a whole host of rules that go along with that. Obviously thousands and thousands of rules and this is where CPAs and public accountants make all their money. So when you take something like digital assets onto your balance sheet, you basically pick up obligations to follow a set of rules on how to treat those.

So what happened is, there's kind of super interesting history here.If you are interested in things like the history of accounting, there is a super interesting history here. So the Bitcoin network was launched around 2008, picked up steam through 2011 and had its breakout year. Then 2014 was the first time that I'd say the accounting industry writ large actually took a serious look at digital assets. And what happened is the big four all kind of got together and sat down and said “hey, we need to analyze this for accounting principles”. 

They asked “is this inventory?” Is this a thing that I paid someone to build that is now sitting in a warehouse that I'm going to sell and physically move it out of the warehouse when I sell it. No, not really.

“Is this this cash?” No, at that point, it certainly was not cash. Like when you only had Bitcoin and Ethereum there's no world where you would have called those cash equivalents. So they ran down the whole list of all the different things that you can kind of treat a digital asset as.

And they ended up on this thing called an “intangible asset”. Everybody has these on their balance sheets, but it's not a particularly common thing to do a lot of manipulation around. So if you were to buy a domain name, you buy jj.com, that $12 you spent on a domain name becomes an intangible asset on your balance sheet because it's not an inventory item, you're not selling it, you're just sort of sitting on it. 

There’s other ways to get an intangible asset but that’s a really easy way to understand. So imagine something like FTX that bought a three-letter domain name. It probably cost them several million dollars to buy the FTX domain name. They’re sitting on this domain name, it's sitting on their books for several million dollars, whatever they paid for it, and then one day do terrible terrible things, hurt our industry, SBFs a complete fraud and suddenly the FTX name is worth literally nothing. 

So they go through this process that's called impairment where they basically take that domain name and they mark it to what they think fair value is. And honestly, fair value for FTX today is not very much, let's call it 10 bucks. That’s probably a bit of an exaggeration but hopefully it gets the idea across.

So you actually have to mark down this intangible asset and you can never mark it back up until you sell it. So basically, once you've picked up a damage to this brand or a damage to this intangible asset you are now SOL. You are at a ten dollar price until you sell it. 

So that's the accounting treatment you apply for crypto at businesses, it's called impairment. What happens is you are basically asked to value the Bitcoin every single day, and if the price goes below what you paid for it, you are expected to take what's called an impairment expense. It's literally like giving money to somebody. So like I go to a store and I spend five dollars on a banner for a conference, that's an expense. An impairment expense is literally the exact thing. It’s your PNL, your investors see it. I’m sure you guys have seen this in the news about Tesla taking a $100 million impairment expense. That's what this is all tied to.

It's sort of a really complicated model. Now, what's happening is it's actually changing. So FASB released some guidance, and they're going to be changing a bit of these treatments. For, in particular, ETH and BTC. They stand out as the ones are going to get changed. Other ones, may or may not.

So, where there's a little bit of confusion right now is that the way they worded it carved out governance protocols. So if you're looking at a UNI token or something like that where there's an underlying right that’s basically being conveyed through ownership of the token, that would be a UNI token.

Or I don't know if you guys saw the news about the house that sold on Solana that had rental property revenue associated with it. Those would all probably still need to get impaired even under these new rules. 

But for Bitcoin and ETH they're doing what's called fair value where basically every day you look at the price and then you pick up either an expense or a revenue item for that. So if it goes up, you just got three dollars of revenue. If it goes down, you get three dollars of expense. And the idea is that over time it sort of balances out. It's a more realistic view of the assets on your blockchain. But either way, even that is burdensome.

For you as an individual, it would be a real pain in the neck, if every day you had to revalue your crypto and report that to the IRS. But in the crypto accounting world, that's what you have to do. Every day you have to revalue your crypto, that has to hit your PNL, that goes to your investors, and at the end of the year, it offsets, but it does have to go to the IRS and things like that. There are other complexities, I won't get into too much, but there are things that are more fun to talk about.

So the technicalities of what can happen and tax rules and things like that are fun if you nerd out on that kind of stuff. But if you nerd out on crypto in general, there's other stuff to sort of think about that is really interesting.

For instance, the people that work for a business in executive leadership roles, CFO, CEO, things like that, they have a fiduciary duty to their shareholders, to the board, and to the business in some ways, around digital assets. Around the cash they’re sitting on and all their assets. When you bring digital assets onto the balance sheet, you actually are picking up a really interesting fiduciary duty and what we would often call a control duty for your organization. 

So, for example, bank accounts are pretty well understood. You have a bank account for your business. You set up a couple of signers, you put an approval amount that Bob’s allowed to only approve 10 dollars, things like that. Crypto, all of that stuff is very nascent. There's ways to do anything you would want in the crypto world, there's ways to set up special multisig wallets that have approval limits, there's ways to set up mpc wallets that have multiple signers and things like that. But you have to do it, right? We don't have a standard game plan that every business can run through.

So when digital assets come onto the balance sheet, if Walmart were to suddenly spin up a project and buy 100 million dollars of Ethereum, they would have to go through a very serious project internally to determine “what are the control mechanisms here”?

Who gets access? How do we control access? How do we audit access? How do we do our financial reporting? As a treasurer, you pick up these responsibilities that just didn't exist. You pick up weird counterparty risks. At the moment that you are holding ETH, if you have employees holding it, suddenly you have a counterparty risk with your employees.

If you're keeping it at an exchange, you have a counterparty risk at that exchange. If you’re keeping it with a custodian, you have a counterparty risk with the custodian. You also have a counterparty risk to the network. We all believe deeply in Ethereum, but take another network like Solana. This is a good example because you are holding this asset, you think you can sell it whenever you want, move it whenever you want, but Solana goes down every couple weeks long for about eight hours.

So now your assumption is not true, right? From a pure internal controls perspective, you don't have free movement of this asset at all times 24/7, 7 days a week. You have this counterparty risk with Solana. So what happens if, when Solana is crashing, the price is crashing, then the network also goes down, so now you can't sell it.

So you pick up these other things that are really fun to think about. Well, fun is maybe a relative term here, but the more interesting thing to think about is how do we control the crypto of our company? How do we think about private key management? How do we think about risk? How do we think about counterparty risk, exchange risk, network-level risk, protocol risk. Euler just had that huge hack and we had a few customers that were deeply impacted by that. So you have protocol level risks with defi protocols.

So when you are a business starting in crypto, there’s a lot to think about. It's a lot of fun, but there's a lot of stuff to think about. You have to think very holistically about the digital assets on your balance sheet.

John: The finance geek in me and the cyber security geek in me like going down that path. Switching gears a little bit because I know we have a lot of validators that are interested in tax issues. Like me, some potential validators have stayed out because of the uncertainty around that. And I would say in the last year a lot has changed. Particularly on the Ethereum network as we moved from proof of work, to proof of stake, where individuals and companies are staking about $31 billion in ETH, securing the network. 

Pat: That’s crazy. It kind of boggles my mind, the amount of money. The cool part about staking is that it was this movement from using chips and energy cycles to using money to secure the network.

This basically means that in order to attack the network you need 10 billion dollars lying around. There's a handful of people that could do that, maybe Elon Musk if he was really bored could do a pretty interesting attack against the Ethereum network. But outside of that it is this incredible, self-sustaining tool that we've all built here. It's so cool. 

John: Super cool, right? There are also these dynamics around MEV which, as we know, is sort of the premium paid to validators for influencing the order of transactions in a block. And I know we've had some conversations prior to this about how that impacts both accounting and tax. But I think one of the really fascinating things that’s on the horizon is the Shappela fork.

It's just 13 days away and all of a sudden all these folks that have locked up all this ETH, almost 18 million ETH, can now have it unlocked. So I’m sure people are exploring whether or not they harvest losses, reallocate assets, restake either in the same place or move it around. 

I think that creates a whole bunch of interesting opportunities and issues. And I’ll open up and let you jump in. 

Pat: 100%. So up to this point, money locked in the Beacon Chain, if you're a business and you have a technical accountant do an analysis of ETH, it ends up looking like a long-term derivative contract where there's some sort of risk-based chance of it being paid out or not being paid out.

And so there are very clear rules for how you handle that in the accounting world. It's a little bit less simple when you get to individuals. This is a great reason you do actually want to have a tax professional around to make some analysis here. End of the day, when we all put money into ETH, there was absolutely no guarantee at that point that that money was ever going to come out. I think we all believed very deeply that we could get it out at some point, but there was no guarantee. 

There was no timeline, the code had yet to be written, there was nothing that would actually guarantee that we could get that money out. So that demands a special kind of treatment where it's almost like a loan in some ways, it’s not exactly a loan, but we basically loaned it to the network.

There was a non-zero chance that they would default on the loan, we have to treat it correctly. We're then getting interest on that loan in some ways. So what I'm gonna walk through here is different ways to describe this to your accountants so they can make a decision about how exactly to treat it for tax purposes. Either at your business or for use as an individual.

Of course, what has changed over the last month is that now we actually do have a hard date in the sand where we are going to be able to pull ETH out. So that intuitively changes the nature of this kind of contract. And I use contract in the typical legal sense here. We have a contract with the Ethereum network. Now, it's not a written contract, it’s not a signed contract, but you do have this contract with the Ethereum network. And now they've come out and said 15 days from now, you're going to be able to withdraw your money.

So what that does is change it from this indefinite derivative where you're actually not entirely sure when it's going to be released, to now having a hard day where this is going to get released and you might have to start recognizing income.

You might have already recognized income, you might not have, there are different ways to have treated ETH to this point. Many people were recognizing income every single day. They would look at their balance every single day. They would then say, okay, that's how much money I made today as it went up, and they would basically recognize it at that moment in time. 

Other people have been sitting on it saying until I know I can withdraw, I'm not going to recognize any income. I'm going to treat this as a liability on my balance sheet until we can actually officially withdraw it because that's on the horizon. 

All of those chickens are going to come home to roost here. So you have to figure out how exactly you're going to treat it. Because we are in this situation where some people haven't done your taxes yet, you can do a little bit of choosing how to recognize this.

I’ll throw this out here for the folks listening right now. Again, there is a natural proclivity to defer recognizing income, defer this, defer that. The “don't pay the government” tactic. But at the end of the day, paying them might be very advantageous. 

If you think about the last year, you’ve basically been DCA-ing if you were to recognize your income every single day on the Beacon Chain. You’ve been dollar cost averaging into Ethereum by buying a little bit of ETH every 12 seconds. And doing that through a bear market where your cost basis has been going down and down and down and down. 

So there’s a very material difference if you decide to recognize all of your income two weeks from now at 1700/1800 dollars versus if you decide to recognize what you've been DCA-ing over the last 18 months. That could be a very material difference between both the income that you got and the cost basis. This is a very long way of saying go and talk to a tax professional that can help you with this. This is not tax advice, go and talk to a tax professional.

These are the different considerations, it’s pretty easy to figure out. Just take your total holdings divided by the number of days you've been staked. Divide that by the average price across that time period and you’ll get some sort of sense for your cost basis on average if you treated it more DCA versus immediate.

Make a decision and then whatever decision you make, you're gonna have to stick with it for the rest of your staking life in terms of if you want to recognize income every day or if you want to recognize it when you withdraw it.

That was a lot of words to talk about the different complexities that come up. Hopefully that is interesting because you really can make two different choices and both business or individuals should talk to a tax professional about how to make those decisions.

John: That was another good point you made Pat that none of this is financial, legal, or accounting advice. Seek the advice of a professional before you make your decision. This is just a discussion. But it does raise a question, if I’m a staker and I staked my ETH at a much higher price than it is right now, if I restake, is there a tax implication? And what if I restake with my own hardware versus restaking somewhere else? Or move it around? 

Pat: It gets really complicated. Because the question about, like, own hardware versus moving around tends to get into this really interesting question about securities. Because let’s say you take it and turn it into Lido or one of the other liquid protocols, suddenly you have really changed the nature of the security. You’ve changed the nature of the contract. You’ve changed the liquidity of it.

All of that will affect both your accounting and taxes as a business running these nodes. You definitely need to keep an eye on it for sure. If you've been using the liquid protocols you are in a situation where you actually had a more liquid asset. It did not necessarily fall under the same kind of derivative terms that we are thinking of and you want to do more recognition of gains and loss up front. Long story short, it's a tough question to answer. 

Definitely talk to an advisor about it. If you have enough money that this matters, it's worth spending a few hundred bucks to talk to someone about it because you could have very, very large differences in your tax liabilities from these actions.

John: I’ve heard that even amongst the liquid staking providers, the way that the rewards are granted can impact your liability. So with Lido it's issuance, vs with Rocketpool the underlying token appreciates.

Pat: Yeah they're both pretty similar. You know, rebasing from an accounting perspective is…there's two parts about it. So one is the token appreciates versus actually changing the amount of tokens you're holding. Both of those different liquid protocols use different mechanisms for how they do it. If the amount of token you're holding changes, that is a taxable or an accountable action, you need to take care of it. 

If it's just the appreciation of the underlying asset, that does leave a little bit more flexibility for putting off your income recognition. But again keep in mind you may still need to do income recognition. There's really no foolproof game here for avoiding the tax man. The tax man cometh. It’s one of the certainties of life.

John: That's great. Now I know this Jarrett v. United States case has received a lot of attention around a Tezos staker. Do you feel like going into that case? 

Pat: Happy to talk about it but I don't have much interesting to add. At the end of the day, the court ruling was written incredibly narrowly and it is not a general thumbs up to never recognize staking revenue until you sell it. 

This was a very, very particular case, where the way that the decision was sort of ultimately handed down, it wasn't a court decision it was an IRS action. A good analogy would be if you're having a fight with your significant other, and you go to a dinner party, and you say “let’s not talk about this right now”.

No hard decision was made, no one won, they just put it off until a later point of time. They just sort of set it aside for a little bit. I would not base anything on it. Because the problem is, the weirder stuff you do, from an accounting and tax perspective, the harder it is to unwind it and you end up paying penalties and things like that.

The IRS has come out and said that specific lot identification is okay for crypto. But there's a lot of squishiness behind there. Does that mean I have to track exactly what Bitcoin address I have crypto in and then spend it from that address? There's all this sort of up-in-the-air stuff around that. So what we see with some of our customers is they actually keep two sets of books. They'll run spec ID in order to get their tax liability optimized, but they will also run FIFO in an effort to basically understand where the tax liability would be in a worst-case scenario.

Oftentimes they’ll keep a certain amount of money around and this is either a best practice or sometimes, depending on your jurisdiction, this is a requirement by the local GAAP. So in Germany, you actually have to keep this on your books so if there's any amount of ambiguity about a particular rule, and you're taking an optimized version of it, you have to keep the full liability on your books forever. 

That's not how it works in the US, but smart companies still stay heads up about what their liability could be and so they'll keep an amount of money to pay FIFO. It's also one of those things where, if they were trying to do the letter of the law, they were doing their best, they’re not going to see massive (and this is not legal advice), but the IRS isn’t going to come after you if you followed the guidance they gave you and then a technicality on the other side changed something. That's going to be a more reasonable discussion than if you try to take a really aggressive stance that's not supported by anything which is where the Jarrett case comes in, because there's no precedent set by that.

So you can't use that precedent. You can't say, hey, based on this, I'm not going to pay taxes on my staking. That doesn't work. It puts you in a much worse position, where you knew you were making money twas liquid, you really should have been accounting for it. The IRS is going to come down a lot harder on that kind of stuff.

It’s something to think about from a high level strategy perspective. But there are people that get paid lots and lots of money at law firms to analyze these risks, understand them, and write a memo the company can keep on their file. Then if the IRS does come knocking, they have something to produce. They can say, hey, we made our best effort attempt to do this correctly by our understanding the law. Here's a letter that we wrote.

But that's a rich person game. That's a big company game. That's not a “I’m doing a little staking on my own that I want to deal with correctly" game.

John: Gotcha. We have a couple of specific questions out of the Lido community. One of the questions is: are there ways to minimize tax implications by not taking direct control of the assets? I.e. Not having authority to buy, hold, or sell at any given time, and then receiving the ETH again.

Pat: Interesting interesting question. You probably want to talk to a professional about it. The direct authority from a legal perspective is different from the direct authority from a crypto perspective. So always keep in mind like there is a delta between direct authority as we tend to think about it which is “do I own the private keys that do this” vs the traditional world. 

Let's say you're trading on TD Ameritrade, you have stock in TD Ameritrade. You don't own that stock. You don’t have the private keys for that stock. In fact, even TD Ameritrade doesn’t. It sits in an account in DTCC which is a central clearinghouse. But you have the right to call TD Ameritrade and tell them what exactly to do with that stock.

So that falls under your dominion of control. That is considered yours. TD Ameritrade can’t arbitrarily sell it unless you entered into a contract with them for margin. You have full control over it (or your estate does if you’re hit by a bus).

So you get to this place where you don’t want to play too many games because if you have any mechanism to control the asset, it is probably under your dominion control. And even if you are kind of segregating ETH out of that, but you have some sort of holding token, the holding token, the Lido holding token itself, is a token that needs to be fair-valued.

You see TikToks and things like this where people talk about this stuff, they say they’ve figured out the most clever loophole ever. But keep in mind that the government has a lot of leeway to ignore the cleverness of your loophole. And the government has a lot more money to fight the legal battle than you do. So tend to take a more government-friendly approach. Tend to assume that the more aggressive governmental stance, the more conservative stance from your perspective, is probably the right one. It's hard to find a lot of wiggle room with these kinds of machinations. 

John: On a somewhat similar note, is depositing ETH into liquid staking considered a sale or simply a receipt of coin(sp)?

Pat: It really depends on the protocol that you're using. But, with something like Lido where you do actually deposit it and you get a token back, that is unique. It’s a really hard question because this also impacts other things like going into a staking protocol like Compound. So when I went into Compound, did I just sell my ETH and buy the Compound ETH token? Or did I maintain control of my ETH but it's now in a different asset that's just wrapped up. 

Because in some ways Lido is kind of a wrapped token, but in many other ways it's not at all a wrapped token because at the end of the day, it has a lot of liquidity. You can sell it, you can buy it, all that sort of stuff.

So it's one of those things where you're going to make a choice in the broadest sense generally about how you want to treat this kind of stuff. Because the choice you're making will tend to influence other things. Like whatever choice you make for Lido will tend to influence whatever choice you want to make for Compound. 

That all does impact your overall tax liability and stuff like that. It's hard to answer in the abstract. But there's a good argument that in that case, that is a disposal and a reacquisition. There's an argument to be made that it's not, but there's a good argument to be made that it is.

But what ends up being tricky about it is you have to be consistent in that. Once you make a decision about how you're going to treat it, because there is a lot of ambiguity from a legal perspective here, you have to ask “am I treating this as a wrapping action where I still own the ETH and I just have a different instrument that gives me the rights to withdraw like a promissory note? Or am I disposing of the ETH and acquiring the Lido?” 

Whichever you decide there a) your tax person should have a reason for making that decision and b) the reason that you used to make that decision, should then apply to other assets as well. So staking into defi protocols, staking into other blockchains, and things like that. 

It's one of the things where you can make decisions there that are advantageous one way the other, but then you have to be consistent about those decisions. You can't just arbitrarily say “oh I did it here, I didn't hear it”, that gets you into trouble if you're going to make a decision like “I’m going into Lido, I still own the ETH and I'm just holding a promissory note” that means that other places where you’re staking you have to treat similarly non-disposal. And then as soon as you do non-disposal, you're aware of things like wash sales and all the other kinds of stuff.

That's all I can really say. It's a hard question to answer. There's different ways to do it and you just have to be consistent about your decision.

John: That makes a lot of sense. Now, we're heading up towards the top of the hour, so I wanted to see if you had any parting advice for people to plan for next year and also if there's anything you would like to announce?

Pat: So a couple things I’ll mention on our side. First of all, if anyone's interested in anything that we've been talking about here today, in particular on the business side, we have a conference. The conference is called the Enterprise Digital Asset Summit. We do it as a piggyback conference with Consensus. The day before Consensus we have a conference In Austin. It's going to be really, really fun. And if you are generally interested in it, please feel free to come. The URL is https://www.edas.live/.

We have amazing speakers from Figment and, obviously, Bitwave, and a pretty spectacular group of folks from the Big Four speaking at this. If you have any general interest in this, please go to edas.live and we have a code, BLOCKNATIVE100 to get you a $100 ticket. 

That's going to be a blast and that's April 25th, I believe the day before Consensus officially starts. So if you're already down in Austin for Consensus, swing by, it'll be a great time. We're going to be announcing a ton of cool new stuff around everything we've been talking about here. We have a really robust set of changes that we have coming out around staking, defi, and all that kind of stuff.

It would be great to see your folks there. Lastly, I'm excited! I've been in crypto since about 2010. I like the bear markets, I like the winters. I don’t know if it’s 100% I like them, but the winters are when you see really cool stuff. Defi summer came around because of the winter that happened over the two years previous to it. These are kind of trying times, they're asking hard questions, but this winter in particular has been so interesting.

With this bank run, this SVB issue we've had, it's been really interesting. A lot of us kind of remember why we got into crypto. I joke about this, I hate banks. We use FRB, I like our FRB banker, they're amazing folks. But at my last startup, we used Bank of America and I can't articulate a person or a company that I despise more than them. It was the most miserable experience dealing with them. And so a lot of us remembered, oh yeah, I remember why I really got into Bitcoin because I hate the current financial system in America so much.

So it’s been interesting. I’ve been hunkering down for 2023 to be this long, drawn-out winter. And then lo-and-behold something reminded us all why we got into crypto and it seems we’re slowly starting to nudge ourselves slowly back towards a bull market here.

John: A little refresher course on why Satoshi wrote the white paper!

Pat: A little refresher course. I saw that and the first thing I thought of was “Chancellor on brink of second bailout for banks”. The SVB one was so interesting because it really encapsulates why we all hate this stuff, because it was very arbitrary. Yellen comes out and says “absolutely there’s no way we’re bailing them out” and then the next day bails them out. It’s not that I want anyone to lose money. It’s not that I wish ill on anybody. It’s not that I want US startups to fail. It’s like, we just want rules that apply to everybody.

And so, she comes out and says “no bailout” and then bails them out and you're like “wait a second, but I thought you said no bailout? Why does this get a bailout because these are startups as opposed to individual lenders?”

It's just one of those things. I'm excited about crypto this year, we're seeing some really cool stuff happening around payments. That's what I'm most excited about this year. As everyone is cost cutting and figuring out ways to streamline their operations, we are seeing these movements towards really using crypto for payments. When I say that I mean USDC, ETH, things like that for real payment use cases that we all used to think about. 

Everyone in crypto at some time has thought about what it means to get paid in crypto or pay someone to buy a coffee. Everyone loves talking about what it means to buy a coffee with Bitcoin or like why you should never buy coffee with Bitcoin or why you should buy coffees, it's a great topic.

Anyways, we're finally starting to see that come to fruition this year. It'll be businesses that do it first, followed by maybe individuals at some point. But we are genuinely excited about the payments use case. We got some really cool stuff coming out around that this year as well.

John: Likewise, we at Blocknative are super excited about building throughout this winter and this spring to come. And we certainly appreciate you taking the time to share your knowledge and depth of experience in the crypto accounting and crypto tax space. I know I'm a lot smarter now, I suspect a lot of people on the call are hopefully smarter. 

Pat: Maybe more questions than answers (laughs) but hopefully some good answers too. 

John: Great answers! 

Pat: This was spectacular, thank you so much for having me, I really appreciate it, brother.

John: Likewise, take care. Once again this has not been financial or legal advice.

*This is not financial, legal, or tax advice. This material has been prepared for informational purposes only*